Computers, office chairs and factories all wear down and lose value over time. Depreciation is how accountants factor that fact into their number-crunching. A depreciated five-year-old computer isn't as valuable an asset as an identical computer bought new, for example. Understanding depreciation helps keep your accounting accurate.
The depreciation schedule for fixed assets depends on their useful life. A $5,000 asset that will last five years loses $1,000 of its asset value a year, for example. However, other factors, such as the salvage value, can alter the depreciation calculation.
You don't have to worry about depreciation when you restock the bathroom with toilet paper. You account for supplies you buy and use up as regular business expenses, Accounting Guys advises. Depreciation applies to purchases that are in use for more than a year.
Advertisement Article continues below this adDepreciable items are known as fixed assets or collectively as property, plant and equipment (PPE), Accounting Tools goes on to explain. Buildings, furniture and equipment are all fixed assets and all depreciable. Land, however, doesn't depreciate, even though it's a fixed asset. Under generally accepted accounting principles (GAAP), you base depreciation primarily on three factors:
Keep in mind that the estimated useful life of property, plant and equipment is just what it says, an estimate. GAAP doesn't require you to peer into the future and know how long you'll use a particular asset. Instead, you can base depreciation on a "useful life of assets" table.
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Accountants have decades of experience crunching numbers related to fixed assets and depreciation. That enables them to create a useful life of assets table – a list of different classes of assets and how fast they should be depreciated under GAAP. For example, Asset Works explains you can depreciate different fixed assets using a table like this:
Whatever fixed assets your business owns, you can find them on a useful life of assets table. However, a fixed asset for one company may be something else at another business, warns the Corporate Finance Institute. If your company sells computers, the PCs for sale are inventory; your office computers are fixed assets.
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Treating the purchase price of a fixed asset as a single expense incurred the year you spend the money would be simpler than depreciation. However, Accounting Tools advises that GAAP and most other accounting standards consider depreciation a more accurate depiction of your finances.
For example, the purchase of a fixed asset that generates revenue over six years should be spread out over those six years, a rule known as the matching principle. A $36,000 truck with a useful life of six years would lose $6,000 in value each year. The matching principle is a paper figure unrelated to market value. Three years in, the depreciated value of the truck in your ledger is $18,000, even if you know you could sell it for more than that.
When you record depreciation, you debit Depreciation Expense and credit the contra account Accumulated Depreciation. A contra account is an asset account that appears on the balance sheet as a negative, reducing the value of the related fixed asset. When you dispose of the asset, you debit Accumulated Depreciation and credit Fixed Assets, wiping the asset off the balance sheet.
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Even though this year's depreciation of your fixed assets doesn't cost you any money, you report depreciation as an expense on the income statement. When you calculate your cash flow, you add the depreciation expense back in, as it's only a paper expense and no cash changes hands.
The IRS allows you to treat depreciation as a tax-deductible expense, but the IRS useful life table and the rate of depreciation are somewhat different from GAAP. GBQ explains that tax law often allows you to depreciate faster, taking a greater percentage of depreciation early on as a tax deduction.
Publicly traded companies are required to produce financial statements that conform to GAAP and then use different depreciation rules when they submit their tax returns. Privately held companies have more flexibility: If they want to use tax rules for all their accounting instead of GAAP, that's an acceptable option. This eliminates the need to keep two depreciation schedules, and some companies find tax accounting simpler to work with.
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One major difference between tax accounting and GAAP is the Section 179 deduction. Rather than look up property and depreciation percentages in an IRS useful life table, you can – in many cases – write off the entire purchase price the first year, according to the IRS. You can use this option for several classes of fixed assets:
Federal tax law limits how much you can write off with Section 179 in a given year. Currently, you can't deduct more than $1.02 million. If you spend more than $2.55 million on Section 179 property in a year, the amount of the write-off may shrink. If you file a joint return and both you and your wife make Section 179 purchases, the IRS treats you as one taxpayer, so you both have to fall under the limit.
The tax depreciation schedule begins as soon as you put the asset to use in your business. This applies not only to purchases but to personal property you repurpose to use in your business. You stop depreciating when you dispose of the asset, or you've depreciated the entire cost.
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